Prime Minister Wen Jiabao’s comment about breaking up what he called the monopoly of the four big state-owned banks is the tip of the iceberg in the fierce internal debate about the role of state-owned enterprises (SOEs) in China’s economy. That debate falls under the general but misleading rubric, financial reform. Yet it is not about privatizing the banks and the SOEs. Nor is it about replacing China’s model of state-driven capitalism with a free-market version. It is, instead, about two critical but related political questions. First, can the Party can still achieve its policy goals–of which the overriding one is maintaining its monopoly on political power–while controlling, through the state, a smaller share of economic output? Second, how far dare it go in risking loosening its political control by shrinking the state sector in order to let the private sector create more of the economic growth it needs to legitimize its monopoly on power?

This debate is going on against the backdrop of a leadership transition, always an unsettling time, and compounded by now being in conjunction with a critical transition in China’s economy. It is widely if not universally accepted among the top leadership, that China’s three decades of rapid fixed-investment and export-fueled growth are coming to their close. The country needs to rebalance its economy to get the sustainable growth that will let it slow the economy without coming to a full-stop, to defuse the debt bombs and deflate the asset bubbles caused by its investment-fueled growth, and to make the great leap forward to clear the middle-income trap and land as a developed economy.

How much structural change does that require, not just economically, but politically? More pointedly, how much further can economic reform go without political reform? It is a debate that has been off-limits, in public and much of the Party, since 1989, not least because it questions the trade-off of continuing rising living standards for living under of one-party rule (with the acceptance of the corruption and cronyism that involves rather than concern for the absence of Western-style civil rights and liberties.)

Hard-line statists and Mao revivalists, the so-called neo-Comms, maintain that the SOEs–and a firm stabilizing social hand–are a tried and trusted means to steer the economy through its present challenges, validated by the 2008 global economic crisis that laid low Western free-market economies. They provide the Party through the state with a mechanism for the administrative guidance of the economy. In the absence of market-based monetary policy tools, the big four banks sit at the center of this web of control dialing up or down the available supply of funds to their SOE customers as required to regulate investment levels.

Economic reformers fear This model are no longer fit for the new task at hand. The banks are inefficient allocators of capital, as the mounting piles of bad bank debt attest, while the SOEs crowd out the private sector, notably small and medium-sized enterprises that will be needed to create the productivity growth, jobs and innovation that China will need for the next stage of its economic development. With the inopportune political demise of Bao Xilai, the ex-boss of Chongqing and poster boy for the post-Maoist revivalists, putting the old guard on the back foot for now, the reformers are taking the opportunity to press their case. They are not calling for the abolition of SOEs, but saying that they need shaking up and scaling back, a case also argued by the Development Research Council/World Bank report on China in 2030, which we described as a “political manifesto disguised as an economic blueprint”.

China has more than 110,000 SOEs, but the 121 “national champions” in the strategically important “pillar industries” that report to the State Assets Supervision and Administration Commission (SASAC) and their big state-owed lenders (separately regulated) are the nexus of the country’s state-directed capitalism. They have a sway over the economy disproportionate to their number–5% of corporations but 40% of GDP at best guesses (nearer 50%, if thousands of small rural local-authority-controlled enterprises are included). In the pillar industries, which include both strategically important sectors and emerging technologies, SOEs control more than 90% of the assets. Their political and economic power have become so entwined at all levels that they have become deep redoubts of vested interest.

Consolidation, driven by merger and acquisition (the number of national champions, for example, has been reduced from 193 in 2003), now means that 40 or the 46 Chinese companies that rank among the world’s 500 largest corporations are SOEs. That only gives the biggest even more economic and political clout with which to defend the privileges they enjoy. The most topical of these is their ready and cheap access to loans from the big state-owned banks. Private companies are mostly forced to turn to unofficial sources and pay usurious interest rates–the issue Wen highlighted and the experiment in Wenzhou is seeking to address. SOEs get favorable tax treatment, and land and raw material subsidies. They are first choice when it comes to government procurement. As with bank loans, it keeps it all within the club. SOE staff have a powerful incentive to defend their turf, too: salaries are five times the average in the non-state sector. The benefits are better, too, and the political access unrivaled.

With the caveat that SOEs as a group are no more monolithic than any other large group of companies across multiple industries, privilege has not turned into performance. Qiao Liu of the University of Hong Kong has calculated that the average return on equity for SOEs to be 4%, compared to 14% for unlisted private firms. But there is a great range among the profitability of SOEs: those in industries dominated by the state are highly profitable; those in sectors with high levels of competition, not so. (Gao Xu, while working as an economist at the World Bank’s Beijing office, made a detailed analysis of SOE performance by industrial sector.)

China’s WTO membership committed Beijing not to interfere in the commercial decisions of SOEs, but as top executives are appointed by the Party, SOEs tend to be politically self-regulating. They take it as a patriotic duty to fall in behind the goals of five-year plans. That is not to say they are docile handmaidens. As players in the patchwork of power and patronage that rules China, they have their own agendas to promote and turf to defend, as well as those of factional interests allied to them. One reason that the pace of financial reform has been so glacial in recent years is that it is seen by SOEs as a threat to their position.

That has not prevented reformers’ long-standing efforts to at least improve the governance of SOEs, by structuring them less like ministry departments and more like shareholder corporations, even if government at some level is the sole or controlling shareholder. The creation of SASAC in 2003 was an attempt to provide external institutional oversight that would promote more professional management of SOEs. More recently, foreign investors have been brought in via offshore listings of SOE subsidiaries in the hope that international management best practice will arrive along with new equity. The biggest SOEs have been pushed overseas in part to experience business in competitive, rule-bound markets that China will, eventually, have to create at home if it is to have balanced growth. This experience has also provided them with a stark lesson in how the rest of the world assumes that even the most commercially-oriented SOEs are an arm of government, as companies like Chinalco and Huawei have recently found out.

Loosening the ties that bind SOEs to state and Party is necessary if China is to give the private sector more scope to drive the growth the county needs to move to the next phase of its development. This goes far beyond just making more credit available to small and medium-sized enterprises, a welcome start though that would be for China’s entrepreneurs. However, socialism with Chinese characteristics, or even capitalism with Chinese characteristics, means that state-owned companies will continue to play a large role in the economy. Privatization, as happened in the former Soviet Union and Eastern Europe, is not on the cards. It is a matter of how small is large.

For foreign companies and investors, some sectors will become more open to them as they will to private Chinese companies. Others, strategically important, will remain off-limits not just to foreigners but domestic private firms as well. SOEs will strongly resist being reined in, as they have successfully done before. They may find the fight tougher this time. The political stakes are certainly higher as the Party confronts its defining dilemma: how to loosen the ties that bind without endangering either economic or, worse, political stability.